LIABILITY IN SECURITIES FRAUD ACTIONS Part XVI: The “Jade Falcon” Standard – The Opinion in Tellabs

Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007) creates a new “jade falcon” standard of for pleading a strong inference of scienter, vesting significant authority in the District Courts.  That standard, crafted by Justice Ginsburg in her opinion for an eight-justice majority, reflects a balanced approach to interpreting strong inference requirement of Section 21D(b)2 of the Private Securities Litigation Reform Act, rather that the pro-defense orientation claimed by many commentators.  This balance is reflected in the Court’s holding, as well as its unstated, but effective rewrite of the procedures for deciding a motion to dismiss under Fed. R. Civ. P. 12(b)(6), which may be the most significant part of the decision.

The balanced “jade falcon” standard requires that “[a] plaintiff alleging fraud in a Section 10(b) action … must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference” (emphasis in original).  While the Court noted that “strong,” according to the dictionary, means “powerful or cogent,” in Section 21D(b)2 the standard must reflect the twin goals of the PSLRA.  The Court described those goals as  “to curb frivolous, lawyer-driven litigation, while preserving investor’s ability to recover on meritorious claims.”  Accordingly, a strong inference means it must be at least equal to other contrary competing inference, not predominant.  

To emphasize the fact that the standard means equipoise and not predominance Justice Ginsburg borrowed and modified a story about a stolen jade falcon from the concurring opinion of Justice Scalia.  In the story, only A and B have access to a room from which a jade falcon is stolen.  The inference that A stole the statute is strong.  The inference that B stole the statute is strong.  Both are strong within the meaning of the Reform Act Section.

In determining whether the strong inference test is met, the Court crafted what it called three “prescriptions” which rewrite portions of the motion to dismiss procedures:  (1) the facts must be accepted as true; (2) the complaint must be considered in its entirety; and (3) in construing the inference, plausible opposing inference must be considered.  The first two points are standard Rule 12(b)(6) procedure.  The third, however, alters prior practice by omitting the traditional requirement that all inferences be drawn in favor of the plaintiff.  The Court also dropped the traditional rule which required consideration of only those facts pled or incorporated into the complaint in favor of a new rule directing consideration of any additional facts of which the district court has taken judicial notice. 

While the Court did not specify what type of facts must be pled to meet the Reform Act pleading standard, it noted that evidence of motive and opportunity might be considered, but that its absence was not fatal.  At the same time, vague and missing allegations can be considered.  Overall however, the key question is whether when considering all the inferences, those supporting scienter are at least equal to those pointing toward an innocent explanation. 

While Justice Scalia concurred in the holding, he chided the majority, arguing that the inferences in the jade falcon example are not strong.  Rather, to be “strong” the inference of scienter should be “more plausible” than the inference of scienter.  Justice Alito concurred with this position as well as the holding of the majority, but would have required that only inferences from facts pled with particularity be considered.  Justice Stevens, in contrast, dissented, concluding that the test should be a familiar one such as “probable cause.” 

Tellabs clearly vests broad discretion in the District Court.  While the equipoise test adopted by the Court reflects what it saw as the cross currents of the Reform Act, the jade falcon approach, in probability, will make it more difficult for plaintiffs to plead a securities fraud claim.  At the same time, the test may reduce the pleading standards in some jurisdictions while increasing them in others.

First, the test vests significant discretion in the District Court.  Tellabs offers little guidance on what type of evidence is required to meet the Reform Act standard.  While the decision puts to rest the debate about motive and opportunity, the District Court is given little other guidance as to what constitutes a strong inference.  Similarly, the opinion does not even give an example of the type of material the court may chose to take judicial notice of in deciding a motion to dismiss.  Thus, much is left to the sound discretion of the District Court.

Second, the directive that all facts be considered – including those which effectively supplement the allegations in the complaint through judicial notice – may in fact increase the pleading burden for plaintiffs.  Under traditional motion to dismiss practice, only allegations in the complaint (including attachments) are considered.  While this approach had been eroded by the courts in securities cases to some extent, it was heavily criticized in the hearing which lead to the passage of the Reform Act.  In testimony, there were repeated claims of flimsy complaints with few facts which selectively quoted corporate SEC filings. The Tellabs directive that all facts, including those of which judicial notice is taken, clearly responds to this testimony, although neither the parties, nor the SEC suggested this position in their briefs. 

In view of this directive, however, securities fraud plaintiffs will have to carefully assess not only the facts and allegations incorporated in their complaint, but also those which defendants may offer and of which the court may take judicial notice.  Overall, this should require a much more careful analysis of all the available facts, not just those which may support a claim.

Finally, the Tellabs test may reduce the pleading standard in some instances while increasing it in others.  In the Ninth Circuit, for example, the standard in In re Silicon Graphics Inc., Sec. Litig., 183 F.3d 970 (9th Cir. 1999) would seem to have been overruled, lessening pleading requirements in that jurisdiction. At the same time, the Second Circuit’s standard in Press v. Chem. Inv. Serv. Corp., 166 F.3d 529 (2nd Cir. 1999) seems to have suffered the same fact, thus increasing pleading requirements in circuits which follow that rule.  Overall, however, the precise impact of the jade falcon standard will have to be assessed after the District Courts have had an opportunity to exercise the large degree of discretion afforded by the new test.

Next:  The aftermath of Dura.